Sunday, June 24, 2007

``Faced with the challenges of managing policy in an increasingly integrated world economy, the dominant instinct of officials is often to try to shield the economy from volatility. But the crises of the 1990s helped demonstrate why this approach can be both futile and counterproductive. As economies become more open to capital flows, policies designed to insulate an economy from external shocks, whether they be fixed exchange rate regimes or selective capital controls and restrictions on international transactions, rarely offer durable stability, and they bring additional risks. These risks come in the form of additional distortions that might undermine future growth or magnify vulnerability to future financial volatility. The more promising approach is to invest in the complement of institutions and policies that enable an economy to live more comfortably with openness. Focusing on those measures that will enable an economy to be more flexible and to adapt more quickly to change ultimately will be a more effective policy strategy. It is politically more difficult, but economically more effective than those solutions that seem to offer protection from competition and volatility.”-Mr. Timothy F Geithner, President and Chief Executive Officer of the Federal Reserve Bank of New York, Trends in Asian Financial Sectors Conference, Federal Reserve Bank of San Francisco, San Francisco, 20 June 2007.

In this Issue:

Introspection on the US Markets and the Phisix

Deterioration in US Market Internals

Taxing Out the Bulls…

As the Yen hits Milestone Lows, We Monitor for Emergent Volatility

Our Phisix Outlook: From Bullish to Neutral

Introspection on the US Markets and the Phisix

THE performance of the Phisix remains remarkable so far, up .81% for the week and up 24.7% year to date. As we have always asserted, this has been so NOT MAINLY because of locally driven factors but because global conditions have prevailed which has been similarly manifested by a mostly buoyant activities in world equities. In our view, it has been the global central banks’ inflationary bias that has determined today’s financially driven asset based world economies.

Where today’s financial markets reflects heightened financial interlinkages and have grown increased correlations relative to its contemporaries compared to the previous years, it has become an imperative to examine the performances of the present stewards in today’s market actions.

Again, US markets has served as a sort of an “inspirational” pacesetter to global markets as much as to our own Phisix. While indeed the US markets have spearheaded a global rebound since February’s “Shanghai Surprise” as reflected by the advances of its key bellwethers such as the Dow Jones Industrials up 6.8%, S&P 500 5.9%, Nasdaq 7.2% based on Friday’s close, this confounding optimism comes curiously in the face of an economic “slowdown”.

What has been observed is that despite the unraveling bust in the real estate sector and continued concerns over the possible ramifications of the subprime mortgage woes, the continued levity in the financial sector has helped buttressed sentiment in the equity benchmarks, giving a picture of a largely unscathed economy, until today…

Figure 1 S & P: Sectoral Breakdown of the S & P 500

According to the sectoral breakdown of the industries of the major broad market barometer in the market value weighted S&P 500, the financials constitute a hefty 21.6% weighting in the index’s universe. What this means is that banks, investment houses, brokers-dealers, mortgage entities, insurances and other financial services represent the largest market cap weightings among US industries.

Figure 2: Yardeni.com: Profits from Financial versus Non-Financial

The significance of the financial sector has not been solely in terms of market value.Relative to corporate profits as shown in Figure 2 courtesy of Yardeni.com, the financial sector signifies about two-fifths of profits generated by Corporate America (All Corporations-Nonfinancial corporations).

Recently, the US financial markets was said to have been rattled by concerns of the recent spike in treasury yields, possibly signifying rising interest rates, as well as, persisting concerns of a possible diffusion by the deterioration in the finances of the housing related sectors. As of late, according to implode-a-meter.com 86 US lenders have now gone kaput.

To add to the lingering anxieties over the broadening of the housing epicenter based tremors, the current brouhaha over the failing hedge funds and Collateralized Debt Obligations or CDO’s appears to have signaled the proverbial “canary in the coal mine” as epitomized by the Bear Stern’s case where the investment house had been forced to bail out one of its two collapsing hedge fund due to substantial losses in the complex portfolio of structured finances (mostly from CDOs).

Lest we fall for the common man’s confirmation bias folly, or a cognitive bias which tends to show how we interpret events to confirm our preconceptions, we’d rather let the market to do the talking.

Deterioration in US Market Internals

Figure 3: Stockcharts.com: Financials Rolling Over?

Earlier we have shown the importance of the US financial sector to the US economy (relative to profits) and to the equity markets (relative to market value weightings). In Figure 3, the charts of the 4 financial benchmarks, S&P Bank Index ($BIX-lowest panel), Broker/Dealer Index-AMEX ($XBD-upper panel below the main window), Dow Jones US Mortgage Finance Index ($DJUSMF-upper window), and DJ US Financial Services Index($DJUSFI-Center window) appears to be indicating an all important turning or inflection point.

The Bank and the main Financial Index has depicted lower highs and are at present working to test on critical supports, while the Mortgage Finance have broken critical support and appears to be rolling over, whereas the Broker/dealer index is drifting within the support areas.

Even the consumer staples 9.6% of the S&P benchmark (not shown in the chart display), which traditionally represents defensive plays (food/beverages, prescription drugs, tobacco and households products), have been shown on a downdraft much earlier than the recent actions in the major benchmarks, alongside with the Telecom services (3.7%).

Likewise, the Dow Jones Transports, a third component in the Dow theory, where the activities of the Utilities, Transport and the Industrial Averages have been used as indicators to either confirm each others actions in support of a trend or deviate to possibly indicate of an inflection point, has been shown in divergence with the Dow Industrial Averages and seen headed south. If such theory holds its utility then the declining Utilities and Transport are indicative of a declining Industrials.

On the other hand, the sectors keeping up the major bellwethers at their present elevated levels are the Energy (10.1% of the index), the Industrials (10.9%), the Info tech (14.9%), and the Materials (3.1%) sector.

In short, of the ten composite industries of the S&P 500, 6 industries representing a significant majority led by the financials, or 61% of total index weightings are presently showing signs of marked deceleration based on price actions.

So what we are so far witnessing are indicators of degenerating market internal actions which could lead to further selling pressures. As to whether the abovementioned fundamentals have prompted these remains to be seen.

Taxing Out the Bulls…

In addition, there could be other fundamental variables that could weigh in for the advantage of the bears. A much less talked about issue by the marketplace is that of taxation.

One of the structural boosters to the recent bout of buying has been due to the “shrinkage” of equity supplies brought about by the private equity boom, the supposed participation by sovereign wealth funds and massive buy backs from US corporations.

One taxation headwind entails a potential curb to the present pace of buyback based on the amended regulation that would close the circumvention of a tax law covering present repatriated earnings.

There have been some foreign subsidiaries of US companies like IBM that have taken advantage of certain legal loopholes to avoid on paying regular corporate taxes on repatriated earnings (IRS section 367 B) known as “Killer B” transactions which it had used to buyback shares.

Recently the US Internal Revenue Services (IRS) discovered the leakage and acted to plug on it, according to Gwen Robinson, whose article was posted at the FT Alphaville (highlight mine), ``On May 31, the IRS announced plans to issue regulations making companies pay US taxes when they buy back their stock, even if the shares are purchased by an international subsidiary. It said the planned ban on the practice would take effect that day, even though the regulations would not be finalised for some time. The new regulations would treat funds used for buybacks as repatriated earnings, making them subject to US corporate tax rates that are usually higher than international rates.”

Simply stated, by lifting the tax incentives to use repatriated earnings to buyback shares, the issue of equity supply shrinkage as a booster to the markets via buybacks from foreign subsidiaries of US companies could have been effectively reduced.

And as if by sheer coincidence we see MOST of the weaknesses from the US markets coming off after the IRS announcement.This is not to imply that the tax laws had CAUSED the decline, but instead to point out that such actions COULD have contributed to the apparent weakness seen lately.

Then there is another tax aspect. This one had been more visible than the “Killer B” transactions as it takes on the much ballyhooed private equity industry.

The US Congress recently proposed to tax the private equity industry that availed of special capital gains tax rates from “carried interest” provisions, as if direct its target to the recent Blackstone IPO.

According to the CNNMoney (highlight mine), ``Carried interest is a portion of the profits from an investment that's paid to the manager. In the private-equity business, it's often used to compensate managers for investing alongside their clients in a buyout.”

Mr. David Kotok of Cumberland Advisors says that such law/s will unduly undermine the incentives for private equity transactions, another pillar for today’s rising markets, quoting Mr. Kotok (highlight mine), ``Private equity deals are measured by the net present value of the exit strategy. Tax rates are a huge part of that calculation. Hence, this tax change is big and it reduces the present value of any future transaction.”

Adds Mr. Kotok (highlights mine), ``Markets are affected even if this never becomes law. The reason is that there is no way to know if it will pass and therefore any new private equity deal may be subject to the new tax structure. Our system exposes taxpayers to taxation once the law is introduced. If it is passed in the future, the date of introduction can govern the start of the tax impact and not the date of passage.”

With governments attempting to tax at everything that seems profitable, it wouldn’t be long where a series of unintended consequences could arise.

As the Yen hits Milestone Lows, We Monitor for Emergent Volatility

Finally there is the issue of the collapsing Yen.

Figure 5: Jack Crooks: Milestone Low Yen on Huge Open Interest Level

The Yen recently hit milestone lows relative to other major currencies. Against the Euro, the Yen fell into an all time record low level. Against the British Pound, the Yen fell to a fifteen year low, while vis-à-vis the US dollar the Yen fell into a four and a half year low.

This has been astounding in spite of the record trade surpluses and foreign exchange reserve buildup.It is remarkable how Japanese resident investors in search of higher returns have invested enormous amounts overseas compounded by the “carry trade” phenomenon which has led to such disproportionate decline to their currency.

While a declining yen could imply for further marketplace liquidity brought about by increased arbitrage to “riskier” assets, as Jack Crooks of the Black Swan Capital points out, the huge open interest in the bet against the Yen makes it appear as if there is no way for the Yen to go but DOWN!

Open Interest is the total number of futures or options on futures contracts that have not yet been offset or fulfilled for delivery (cme.com).

The significance of an open interest in the futures market is that it reveals the prevailing investor sentiment. According to George Kleinman, editor of Commodities Trends is that (highlight mine)``The size of the open interest reflects the intensity of the willingness of the participants to hold positions. Whenever prices move, someone wins and someone loses; the zero sum game. This is important to remember because when you think about the ramifications of changes in open interest you must think about it in the context of which way the market is moving at the time. An increase in open-interest shows a willingness on the part of the participants to enlarge their commitments.”

In Figure 5, courtesy of Jack Crooks, Yen’s record low decline against the US dollar has been accompanied by a huge spike in open interest.

In other words, investors have taken the decline of the Yen as a ONE WAY BET. And as a market saying goes, when everyone thinks the same then no one is thinking.

One way bets implies that an inflection point is imminent; this should also hold true with regards to the Yen. And a volatile yen could easily translate to equally volatile markets worldwide if one goes by the past behavior of a rising Yen. Recall the May 2006 and Feb “Shanghai Surprise” volatility? They were accompanied by a spiking Yen.

Our Phisix Outlook: From Bullish to Neutral

The coming week could be very interesting indeed. We could probably see a continued selloff in the US markets or a rebound off from the lows or a period of indecision or consolidation with a downside bias.

However, with the sentiment momentum going for the bears, aside from the deterioration in US market internals, and fundamental obstacles to the present bullish drivers, I am inclined to take the position that the US markets could try to ingest more profit taking sessions over the coming week or so.

Note, there is a difference here; I am predisposed to view of the any downdrafts as mere corrections or profit taking than a crisis at work, until of course proven otherwise.

As for the Philippine market context (as well as for most of its neighbors), there are two opposing forces at work.

On one hand, the bearish side is that as mentioned above, declining US markets could imply for a “short-term” spillover into the global markets. This would highly depend on the degree of volatility in the US markets.

However, the present market reactions have been distinct from the past.During the past encounters of volatility, we saw the US dollar firming, a broad “risky” asset class selloff (emerging markets, junk bonds and commodities) and a rally in US treasuries (declining yields).

On the other hand, the bullish premise for the Asian markets remains as formerly argued, the softening US dollar.

Today, we see a semblance of the “stagflationary” outcome similarly seen in the 70-80s, while one week does not a trend make, last week’s actions showed that infirmities in the US equity markets (Dow Jones Industrials and the S&P 500 down 2% over the week while Nasdaq down 1.44%), have been conjoined with a stubbornly high US treasury yields (drifting at the upper range; or at 5.138% from last week’s 5.17%), rising oil prices (WTIC over $69), relatively high commodity prices and most importantly a falling US dollar.

Another interesting aspect is the potential for a divergence to emerge, where Asian markets may continue to rise amidst a struggling US market, which actuality is long term expectation. Be reminded that the divergences could emerge only under the premise of orderly developments and not from excessive volatilities.

Where in the past the Phisix fell hard and steep as the US markets got clobbered, recently we have encountered sessions wherein steep declines in the US markets resulted to marginal declines in the Phisix.

With two contrasting forces, it would be difficult for us to make a short term call on the overall direction of the market.

From our end, we shift our outlook from bullish to neutral stance for the time being and would remain vigilant as to any incidences that may reflect an adverse “tailed event”.

First of all I’d like to greet all fathers a Happy Fathers day (Including my thoroughly missed Dad who now sits with St Peter.)! This issue is dedicated to all you fathers….and of course to the loving mothers in support of us.

``Ain't only three things to gambling: knowing the 60-40 end of a proposition, money management and knowing yourself.”- Walter Clyde Pearson Tennessee Poker champ

I watched in HORROR when a TV news documentary portrayed the stock market as some sort of variant strain of a “milking cow” for the public last Thursday.

The prime time news documentary highlighted a twist of fate by an “accidental” stock investor who happened to turn into a “millionaire” over a short period of time.

The featured “heroine” swaggered about her “garbage-to-gold” experience by having her 40,000 pesos investment converted into 1 million pesos or an amazing 2,400% return!

And after the initial success, she unabashedly declared herself to have been transformed into a “basura queen” (master of “penny” stocks or highly speculative issues), where her virtuoso performances has enabled her to luxuriate on a new lifestyle.

While of course, the show “feigned” to secure a “balanced” commentary from a high profile mainstream analyst, which ostensibly proved to be greatly inadequate (how does one explain a relatively complex dimension in a few seconds?), the media’s message has been inexorably predetermined; the stock market is today’sdu jour source of easy money!

Because we frequently decry news reports as habitually attempting to simplify events in order to sell SENSATION to the public rather than objective reportage, the TV program obviously failed to point out major inconsistencies into the allegations of the featured protagonist.

While it is true that there are many issues that has performed superbly; similar to or even over the degree of the returns cited, and likewise it is true that our hotshot has had indubitably achieved her millions by surfing today’s rising tide, one significant source of inconsistency is her changeover from a chanced “passive” investor to a “momentum trader”.

She claims that it was years before when she placed 40,000 pesos into the market and suddenly “realized” that it had evolved into 1 million pesos, from which according her words, ``once a “basura” issue turned into “fundamentals”” (whatever that means).

Obviously it was the passive “buy and hold” approach which delivered to her such magnificent gains, yet upon the realization that she could reap a windfall from the market, adopted herself into a self declared “momentum” trader, ergo her self baptized “basura” queen.

Our experience is that momentum trading while pulsating and electrifying as the ticker goes, hardly delivers the meat, as timing the markets or securities fluctuations over the short-term is proven to be a futile exercise. Notice, in today’s trending market, most of what we’ve sold, in the assumption that it would go lower, we’d have to buy back higher.

Such conflicting behavior leads us to question on the validity of her claims. If she realized that her bonanzas came from a passive approach and NOT from timing the markets, it would be quite obvious that she’d chose the former path, right? Apparently not.

In short, our stockmarket ace has been nothing more than a fortuitous investor metamorphosed into a stock punter, buoyed by the rising tide, glorified and extolled by media.Is it a wonder why we Filipinos have been sooooo obsessed with the EASY money dependency culture?

Once again playing your skeptic, could it be instead the 40,000 pesos represented the residual value of a previous losing investment in the past which resulted to her initial passivity?And with confidence rediscovered by virtue of the stock’s recovery and attendant ego magnified by the recent astronomical gains, have turned our superstar into a chronic “exuberant and unrepentant” gambler?

What we understand is that media didn’t ask for evidence through confirmation receipts to back such claims but rather relied on personal declarations as a truism and as basis for their presentation. And as we know, it is the nature of people to brag about their victories (real or imaginary) and shun the ignominy of setbacks. In the words of Plato, ``Wise people talk because they have something to say; fools, because they have to say something."

Given the benefit of the doubt that we take such portrayal on face value, again we would like to point out of the emergent perils symptomatic of the cyclical transitions as manifested by burgeoning risk appetite, excessive optimism, overconfidence, euphoria and excitement, all of which are part and parcel of what shapes our economic, business and even financial markets cycle as shown in Figure 1.

Market cycles are mostly determined by human psychology where in the Philippine setting, the cycle has evidently evolved from a period of despondency in 2002 into today’s incipient manifestation of optimism.

Eventually, optimism will be replaced with widespread excitement and thrill until finally euphoria permeates, where everyone would think that the markets can do NO wrong.

As for our superstar, we believe that she is indeed serendipitous enough to capitalize from the fledging optimistic phase, despite her “euphoric” demeanor. However, once the euphoria spreads to the general public, much like a bush fire to a forest fire, greatly abetted by media then it would be a principal concern for us.

Yet, like in all cycles, a significant majority would end up losing MORE than their accumulated gains from the markets, as cyclical downturns will in most instances catch most investors off guard, aside from of course the added use of leverage in order to amplify their positions to maximize gains.

1997 should be a good reminder, where the Phisix fell from about 3,400 to nearly 1,000 or about 70% loss fueled by the Asian crisis.Legendary trader Jesse Livermore describes the human nature best in the face of stock market investing ``The stock market never really changes that much. What happened before will happen again and again and again."

``The problem of overcausation does not lie with the journalist, but with the public. Nobody would pay one dollar to buy a series of abstract statistics reminiscent of a boring college lecture. We want to be told stories, and there is nothing wrong with that-except that we should check more thoroughly whether the story provides consequential distortions of reality (highlight mine).”

In other words, investors have to learn how to fend for themselves in winnowing and filtering the validity of data presented and its utility to the decision making process and understand media’s role in sensationalizing information. Borrowing the aphorism of sixth-century B.C. Chinese Philosopher Lao-tzu``He who conquers others is strong; he who conquers himself is mighty.”

HOW HUMAN PSYCHOLOGY DRIVES the BUSINESS CYCLES

As for human psychological phases transmitted into business/economic cycles, we observe similar curve patterns as shown in Figure 2.

Business cycles run under the overinvestment and underinvestment themes.

During an economic downturn or the contraction phase, market clearing forces the previous excess investment to be liquidated, hence are backed by psychological characteristics as the benign “anxiety” phase, working its way into a deeper “denial” phase then to a more desperate “fear” phase.In Wall Street, this stage is called as the “Descending on a ladder of hope” phase.

Eventually, the bullish stragglers “capitulate” and then turn despondent which lead towards a cyclical trough or a period of underinvestment.

On an economic expansion phase we see old investments recover from depression which results to extraordinary large profits.

The allure of large profits entices new investors to eventually hop in and provide for competition. As the gains become more entrenched and pervasive, the economic cycle or the “recovery phase” accelerates in momentum. Here we find positive human traits as hope and relief prevail over the economic landscape and the financial marketplace.In Wall Street this phase is known as “Climbing the Wall of Worries”.

As advances or progress get embedded, the self feeding cycle leads to prosperity, where optimism intensifies. At the height of such optimism investors would likely miscalculate the demand in the marketplace and overestimate on the perceived future gains which eventually results to investment excesses. And then cycle revolves.

Of course, there are other major contributory factors to the economic or financial market cycles such as regulatory policies, technological advances, demographic trends and etc.

However, I find the monetary inputs from governments as one major influence factor. From the Austrian Economics point of view, business cycles are wrought by the interventions of the government in the marketplace by the use of monetary policies, which brings about distorted signals and induce entrepreneurs to miscalculate, thereby resulting to malinvestments or the boom bust cycle.

According to Mises.org’s Dan Mahoney, ``Time preference is the extent to which people value current consumption over future consumption. The key point of the Austrian business cycle theory is that interventions in the monetary system—and there is some debate over what form those interventions must take to set in motion the boom-bust process—create a mismatch between consumer time preferences and entrepreneurial judgments regarding those time preferences.(highlight mine)”

There is also the issue of excessive leverage in the financial system (again monetary induced but this time through the credit system) which eventually contributes to the boom bust dynamics.

As discussed in our March 5 to March 9, 2007 Edition see US Markets: Risks of Ponzi and Speculative Finance, Hyman Minsky’s Financial Instability Hypothesis enunciated on the evolving structure of the credit markets, first shaped by stability and ultimately gradating to one that destabilizes.

Mr. Minsky identifies the three income-debt relations for economic units as hedge financing, speculative financing and finally Ponzi financing. Where the credit structures are initially founded to fulfill all obligations (hedge) then progressing into payment on income accounts on interest only leaving out the principal (speculative) to a more severe form of debt structure by pyramiding where both principal and or interest cannot be complied with by cash operations but instead rely borrowing to finance the outstanding liabilities (Ponzi).

Subsequently, Ponzi schemes signify an offshoot to overinvestments and collapse by its own weight.

How to benefit from STOCK TIPS and stop blaming others!

Yes today’s optimism has unassailably filtered into the general public. In fact, I have received many queries from different quarters over the different avenues (coming from those who knows or have an inkling on what I do).

And many investors perceive today’s market as astonishingly almost “risk free”.How circumstances have changed, radically from 5 years ago.

Nevertheless in most instances, I am asked of WHAT particular issue to bankroll them. In fact, some of my encounters include expectations of incredible outsized returns, even prior to last Thursday’s TV documentary, which had been picked up from their social circles.

When I try to explain that investing entails risks and opportunities management, which highly depends on their risk profile, their expectations on returns and time preference, I usually get a cold shoulder. Instead, I am thought to be self-indulgent.

How difficult it is for the public to understand that investors operate on risk-reward trade off.That trying to predict markets over the short term is tantamount to horse racing. To quote Dr. Marc Faber, ``Concerning the timing, I am the first one to admit that to press a button and say this is the low and press it again and say this is the peak, is very difficult. I am not sure if anyone has successfully managed to do that. I always look at what is the risk and what is the reward of an investment.”

Again, as an analyst-trader/investor we work on the crude probabilities of the market’s directional flow and act accordingly to its cyclical progression. We are not in the works to predict the future as clairvoyants.

While we may have our predilections over (investment themes as published in our outlook) some issues, we don’t know and can’t predict on which issues will be tomorrow’s darlings. Yet, this is what is expected of us; to deliver tomorrow’s returns. In today’s market, select companies have reached BILLIONS in market capitalizations which does NOT even have a million pesos worth of assets! If markets are a mystery, so be it. We won’t be lulled into taking inordinate risks.

Our predisposition has been mainly to position on our investment themes and wait for their maturity and anticipate the cyclical if not secular (long term) transitions rather than trying to second guess who tomorrow’s favorites are.

It is in the same tradition, Edwin Lefévre writing in behalf for Jesse Livermore in the must read Reminiscences of a Stock Operator warned that people do not want to think or work but only wish to be “spoon-fed” or given stock tips.

For instance, if I give you a tip and since your entry position has been directed by me, then it should follow that your exit position should likewise be based upon my tip to ensure the efficacy of my “tips”.In short, since your position depends on me, such “tip based” trade serves to measure the tipster’s or my accuracy in determining the trade’s outcome. That should be the protocol.

Yet, when we get tips that end up with bad results we usually engage in finger pointing. Why? Because we usually don’t follow this route, we end up heeding the tip but usually become unaware of our exit points. Even if a tip does accurately move according to the direction of the tipster’s advice, but since the exit position had not been determined, then the burden of success of the trade has essentiallyshifted from the tip giver to the tip receiver. And when the security or the markets in general move against your positions, the inability to establish exit points parlay to losses, from which we tend to blame the tipster.Is this fair? Obviously not.

Why? Such is known as a psychological delusion called Transference, which according to Author Robert Ringer (emphasis mine),

``the act of looking to others, or to “uncontrollable” circumstances, for the source of one’s problems. When you insist that something is not your fault, what you are unwittingly saying is that you cannot change your situation because you have no control over it…

``Even when you suffer as a result of someone else’s bad behavior, you do yourself no favor by blaming your pain on that person.There is a difference between engaging in transference (blame) and trying to analyze the reason you incurred the problem.

``There is always a reason for a bad consequence, but a reason is far different from an excuse. An excuse is nothing but a clever way to escape accountability. The fact that someone was dishonest with you could be a legitimate reason why you were harmed, but it is not a valid excuse for abusing your own Machine.”

Since most in the investing public have either been dismissive or ignorant of the dynamics that stockmarkets operate under human psychology as its main driver, one of our reasons in not giving out specific stock tips, aside from abiding by Jesse Livermore’s rule, is for our investors to pay heed to the lessons of cognitive illusions.

Any tips that you desire to heed should include an entry as well as an exit point, to lay the burden on your tipster. Otherwise we are ACCOUNTABLE for our actions and NO ONE else!!!

NO REGRETS, I SHOULD HAVE….

Further, in relation to cognitive biases, you should be familiar with these very common phrases:

I should have bought at the bottom; I would have gained a remarkable….I should have sold at the top, I would have bought myself some brand NEW….If I held onto this issue I would have been a ….If I shifted to this issue I would have gained more than…

One of the reasons why the investors are hesitant to act on making important decisions is the fear of regrets.And those fears as encapsulated above are specific examples.It is known as the REGRET THEORY, where according to changingminds.org (highlights mine),

``People know that when they make a decision they will feel regret if they make the wrong decision. They thus take this anticipated regret into account when they decide. This is probably what makes them loss-averse.

``When thinking ahead, they may experience anticipatory regret, as they realize that they may regret in the future. This can be a powerful dissuader or create a specific motivation to do one thing in order to avoid something else.’

Again, it should be emphasized that the essence of investing is about anticipating returns as a trade off in relation to risk based on one’s risk profile, returns expectations and time frame preference.All other aspects naturally become subordinate to these.

Let’s make an example; stock XYZ in 2002 was worth 1 peso at its low and fortunately enough we were able to acquire them at 3 pesos in 2004.Today, stock XYZ is worth 8 pesos. What do we do now?

Let us assume that 5 years in the future the stockmarket peaks and by then stock XYZ will be worth 40 pesos. Then, in the next 5 years the falling market will drag stock XYZ back to the 5 pesos level.

Easy to say, since by virtue of fait accompli allows one to know where to exit, simply is because the past is unchangeable.

However, given today’s predicament, where the secular/cyclical climax has yet to be determined…what does an investor have to do? Cheer prices up to 40, then “deny-until-death” that prices have been in decline and finally revert to its near long low at 5 pesos?

Such would mean reaching the top and the bottom without taking ANY action, prompted by the fear of opportunity loss. In the end, all that cheering and sulking will end you up with a probability of net loss due to inflation. So what good does inactivity or directionless trade/investing make?

Let us further assume that stock ABC in 2002 was worth 1 peso. And that today it is worth only 2 pesos, far from the returns provided for by XYZ. However at the peak of the market cycle stock ABC will end up at 70 pesos per share higher than XYZ only to fall back to 3 pesos at the trough of the cycle 10 years from now, which is lower than XYZ.

Again under the present circumstances, what does an investor do? Maintain position and ignore or effect a switch? At what instance does one decide to take a shift?

These questions are difficult to answer because the future is unknown. We can only make our estimated guess of the market’s future whereabouts and act on contrived possibilities and their respective probabilities.

In essence, prices are relative; it will not always go up neither will it go always down unless under certain exceptions-fundamentals take it to the bin (e.g. insolvency) or to heavens (revolutionary discovery).

However, the general trend determines the price path, as we previously argued which is etched by the secularity/cyclicality of the financial markets and/or economy. Regrets on taking action will only compound to one’s miseries. Nor would we like to live in fantasy land.

The key point for an investor is to have specific goals and contingent plans to work with and apply action triggers under conditions operating under perceived possibilities.

Wake Me UP from MY Nightmares Please

Going back to the elements of horrors which affected me as impelled by the TV news documentary:

1. Bubble Risks.

If media barrages the public with constantly misleading depiction of the stockmarket, we could likely see an emergent bubble in the near future as the clueless throngs will dash into the market to gamble, ala China. Think of maids, drivers or janitors joining the mad rush to speculate on the markets.

This would either bring an abrupt end to the present cycle or create huge price swings or gyrations, enough to send us to the ICU.

2. Security Risks.

Criminal elements could target the industry mainstays, associated professionals and participants or investors known to have reaped a windfall and officials in publicly listed firms.

3. Political Risks.

Self righteous political personalities including their conduits could utilize the pretext of mounting inequality to slap legislative actions against the financial markets industry, such as levy additional taxes, impose capital controls, curb investor rights and access to financial markets in the name of wealth redistribution.

Sunday, June 10, 2007

``The rise of China -- and of Asia -- will, over the next decades, bring about a substantial reordering of the international system. The center of gravity of world affairs is shifting from the Atlantic, where it was lodged for the past three centuries, to the Pacific. The most rapidly developing countries are in Asia, with a growing means to vindicate their perception of the national interest.”-Henry Kissinger, a former secretary of state, chairman of Kissinger Associates

LAST week we pointed out that aside from the overbought conditions seen in the US markets, which has been providing the leadership for global equities, one potential trigger for a correction was the continued spike in US Treasury yields.

A spike in yields could be interpreted as “tightening” of liquidity in the financial marketplace, which again does not bode well for the equities in general.

However, this comes in the face of persistent chitchat by domestic mainstream analysts of China’s market bubble as having a major influence on Asian markets, including that of the Phisix.

As we have argued last week or even in late February where the first “Shanghai Surprise” transpired, we believe that China’s market has manifested little signs of interdependence with Asian markets due to major fundamental reasons such as having a closed capital account, heavily regulated financial markets and extremely limited exposures by foreign investors as well as domestic investors.

Figure 1: stockcharts.com: Phisix-China: What correlation?

We noted that even as China’s markets fell apart, investors of the Phisix and most Asian markets went into a buying spree last week. And in contrast, this week as the tremors in the US markets were equally felt elsewhere, China’s markets took steps to recover from the recent shakeout, as shown in Figure 1.

The blue arrow tells us that Emerging markets (upper window), Asian markets ex-Japan (lower window) and the Phisix (center window) simultaneously in a corrective downdraft even as China’s Shanghai market appear to have convalesced. From which we ask: How germane the correlation of China’s Shanghai index and the Phisix?

Said differently, while we saw China as having initially been used as “scapegoat” for the much needed “profit-taking” from the overheated markets at the end of February (have we not been saying so as early as last quarter of 2006?), the global equity markets today appear to have discounted the relevance of Shanghai’s activities.So aside from fundamental reasons we initially broached, we can now see a stark price disconnect.Again, it seems that our views have once again been validated.

Yet local mainstream analysts find causality in presumed patterns that has never happened or has misinterpreted “coincidental” events as having cause and effect links. In behavioral finance/economics such is part of the “Cognitive bias” (human perception of reality) which is in particular is called as the Clustering Illusion or “seeing patterns where none existed”.

Yes, we think that China’s market today has exhibited signs of extreme froth or “bubble-like” conditions and envisages the risks of either having pronounced gyrations or of an implosion anytime. Yet, there is also a big chance that it could even go higher before its reckoning period, as discussed last week.

However over the long term (10+ years), we infer that since China has been cognizant of the importance of fostering a market-based economy for the nation’s wealth creation, it has acted gradually by rehabilitating its financial markets (enactment of property laws, expanding into more complex or sophisticated markets as the financial futures and gold market, has expanded supplies by amending the “non tradable shares”, gradual opening of its capital markets through the QDII and QFII programs) to reflect on allocation by price efficiency.

And those incremental steps to deregulate and adopt new market mechanisms are likely to provide a floor to any interim volatility. In other words, as China’s economy grows, the contribution of its financial markets in providing and intermediating capital becomes an imperative, as it veers away from its traditional form of financing, i.e. through banks, hence all these cumulative steps to amend the present system. These should support China’s asset prices over the long term.

Likewise we believe that as China’s markets opens, deepens and matures the likelihood is that our Phisix over the long term will increasingly cultivate deeper interrelations with them as well as with other major Asian financial markets (Singapore, Japan and Hong Kong).

This should be a lesson for us, since financing requires market based valuations and liquidity in channeling savings into investments. Finance without adequately functioning markets leads to the same inefficiencies of the past.

``Whether through asceticism, ideology, religion, advertising or other means, whether consciously or not, the elites in all societies manage desire-the starting point of wealth creation. Obviously, just pumping up the desire level-or for that matter, extolling greed, which is different from either wealth or desire-won’t necessarily make anyone rich. Cultures that promote desire and pursue wealth do not necessarily attain it. On the other hand, cultures that preach the virtues of poverty usually get precisely what they pray for.”-Alvin and Heidi Toffler, Revolutionary Wealth

Now going back to the world markets, the world bond market tells us of some risks to be concerned of.

US coupon rates jumped across the yield curve as global bonds got crushed.This has been occurring as global Central Banks has been on an interest rate hiking mode; where New Zealand and the Euro zone were the latest to raise rates this week.

Figure 2: US Treasuries and emerging market yield spikes!

The inflationary policies adopted by global central banks have now started to permeate into consumer price indices. In the same sphere, we see government intervention (in forms of subsidies) in the energy markets have likewise contributed heavily to the law of unintended consequences; raising steeply corn prices that triggered the tortilla crisis in Mexico and the spiraling pork prices in China!

Legal mandate and subsidies on corn as feedstock to the biofuel programs have led to a sizable shift in demand for corn (in competition to its traditional uses; food, animal feed, sweeteners), aside from the reallocation of acreage into corn plantation at the expense of crops. This has likewise prompted price increases in other products, such as soybeans, cotton etc.

According to McKinsey Quarterly’s article Betting on BioFuel, ``From 2003 to 2006, the percentage of the total US corn harvest used to produce biofuels rose to 16 percent, from 12 percent. But now that the federal government has adopted a goal of 35 billion gallons of alternative fuels a year by 2017, the use of domestic corn-based bioethanol to meet even half of this target would require 40 percent (emphasis mine) of that year’s expected harvest. Not surprisingly, the cost of corn has soared: average wholesale prices rose from $1.90 a bushel in 2005 to $2.41 in 2006, and corn has regularly surpassed $4 a bushel on the spot market since late 2006.”

``Other unintended consequences of greater demand could bring a consumer backlash like the one that broke out in Mexico when tortilla prices skyrocketed because of bioethanol-related corn shortages. Environmental concerns were also raised after last autumn’s burning of Indonesian forestland to make space for palm oil crops that were linked to increasing demand for biodiesel. The environmental impact of other aspects of biofuel production, including the widespread cultivation of fast-growing jatropha (a plant that produces a toxic vegetable oil), are unknown.”

Again as we have long forecasted, we remain bullish on the domestic agriculture industry in spite of its downtrodden state, primarily because of its prolonged era of underinvestment in the light of the dramatic wealth induced demand growth in emerging countries equally matched by the multifaceted supply constraints from rapidly developing emerging market economies (such as demographic and urbanization trends, rising incidences of desertification, industrialization, chronic water supply shortages), the weakening US dollar and now, the effectual distortions emanating from government interventions in the marketplace due to energy and climate change requirements.

As shown in Figure 2, bond prices have accelerated their descent in the US (upper window), as well as in emerging markets (lower window), as 10-year treasuries yields nearly topped its 2006 high (center window).

In the US, Chief Economist Paul Kasriel of Northern Trust believes that rising consumer price inflation, or New Zealand’s policy actions or inflation expectations have NOT been responsible for the present activities in the bond market.

Instead he argues that perhaps the recent bond market rout could have been an outcome from a spate of market activities which included hedging out of growing mortgage prepayment risks, Mr. Kasriel says (emphasis mine),

``When bond yields started creeping up a few weeks ago, mortgage portfolio prepayment risk started creeping down. This meant that the massive amount of mortgages in portfolios needed fewer non-callable Treasuries as duration maintainers. I am not saying that something perceived to be fundamental by bond investors has not changed. But what Lahart is saying is that the massive duration hedging required by mortgage portfolios acts as a supercharger to fundamentally-induced changes in yields. Remember 1994?”

This means that that rising rates has prompted for higher mortgage rates, which likewise increased the risks of fewer prepayments. And with high inventories of mortgages, mortgage investors could have either sold mortgages or hedged their portfolio by selling US treasuries, as expectations for rate cuts have diminished.

And another possible unseen reason could have emanated from declining interests with US treasury purchases by foreign investors, adds Mr. Kasriel (emphasis/highlight mine)…

Figure 3: Northern Trust: Less Purchases from the Foreign Official Holdings

``I will, however, add one fundamental factor that may have played a smaller role in this week’s bond market selloff – foreign official holdings of U.S. Treasury and Agency securities. As the chart (Figure 3) shows, in the week ended Wednesday, June 6, there was a relatively large $12.5 billion reduction in these custody holdings.”

Our take is that if this is an emerging trend where foreign central banks have shown lesser appetite to prop up US assets then the likelihood that the rally seen in the US dollar recently could merely serve as a blip.

``The potential of the carry trade as a source of future exchange rate volatility has brought back memories of October 1998 when the yen collapsed against the dollar as hedge funds unwound carry trades in response to the Russian financial crisis.”-Peter Garnham and David Pilling, Financial Times

Well, some have argued that the recent plunge in US and global stocks have been due to the unwinding of the carry trade.

Figure 4 tells us that the so-called CARRY Trade has NOT been much of a factor in the recent selloff YET, as both funding currencies of the Japanese Yen (upper window) and the Swiss Franc (lower window), has contrary to expectations, continued to encounter marked declines amidst rising volatility.

Instead we see a rallying US dollar traded weighted index and a return to a positive yield slope in our midst. (Yes the Philippine Peso declined abruptly by 1.28% to Php 46.67 alongside with most of the region’s currencies, aside from an equivalent tremblor in the region’s bond markets).

The Carry trade assumes borrowing or shorting low yielding currencies and utilizing the proceeds to invest in higher yielding currency/assets. However if the costs of these currencies rises, there could be pressures to sell the invested assets and payback the loans or buyback the shorted currency, where such offsetting transactions would result to across the board selling pressures in the traditional high risk asset market classes like the emerging market assets, commodities and corporate junk bonds. We have not seen this happen yet.

In other words, if one were to speculate on whether today’s shakeout has impaired the system of leverage from which the global markets operate on, then the depiction of insouciance by the Yen and Franc as funding currencies to such levered transactions shows that either these Carry trades have produced insignificant bearing in last week’s activities or has not reached its stress level enough to trigger the purported systemic risks.

Considering the actions of the tape here and abroad, what we are in essence witnessing is a simple return to cash, from regular profit-taking activities, instead of a market bedlam as some bears suggest, of course, until prove otherwise.

Let me quote Chris Gaffney, Vice President of the EverBank World Markets, ``Eventually this cash will need to be put back to work, or will be used to pay off the loans which many of these investors have used to create the explosion of liquidity we have seen over the past few years.As I have said in the past, many loans are denominated in the lowest yielding currencies, the Japanese Yen and the Swiss Franc.If / when investors finally decide to pay back these loans, they will need to buy both of these currencies and the 'carry trade' will be reversed.As I mentioned above, I think blaming a reversal of the carry trade for the move in currencies overnight just doesn't make sense (emphasis mine). But, at the same time, I do believe we have seen the first step in a reversal of this trade.”

``Gold has worked down from Alexander’s time…When something holds good for two thousand years I do not believe it can be because of prejudice or mistaken theory”- Bernard M.Baruch 1875-1965, American financer, stock market speculator, statesman and Presidential adviser

If inflation concerns had been a key factor in the recent selloff in the bond markets, as media portrays them to be, then we should have seen rising metal prices. Instead metal prices fell significantly, perhaps impelled by cross market leverages, where losses in margin accounts in one market have compelled collateral selling on the other.

In Figure 5, over the long stretch, we see a strong correlation of the US-dollar, Fed fund rates and precious metal prices where each time the US dollar falls (green line), despite rising interest rates (red line) we see precious metals (blue line) move higher (1977, 1985, 1993).Of course such correlation has not been in lockstep but the odds are given the same inflationary dynamics, history should rhyme.

Sunday, June 03, 2007

``All professions are conspiracies against the laity." George Bernard Shaw

MAINSTREAM media and their clique of experts has it all figure out; first it was the elections a.k.a “peace dividends” that spurred the Phisix breakout following the culmination of the national elections. Then last week’s one day selloff was no more than from local political developments and to some extent influenced by China’s tremors (again!). And finally, Friday’s FRESH milestone RECORD high had to be from no other than better-than-expected Economic Growth Data.If only markets worked as simple as media projects them to be….

ANY SENSIBLE market observer knows that the rudimentary function of the financial markets is the extrapolation of future outlooks by discounting them to the present. On the contrary, we are then made to believe that markets (or any germane social subjects be it economics, politics, etc…) operate on a backward process; the public prices securities as a matter of historical actions, particularly event based impelled actions. Why would anyone buy on a financial instrument based on the past? Unless, of course, we presuppose that such activities will CONTINUE way into the future. The 64 billion pesos question is WILL THEY?

In the CONTEXT of media, this makes us a “seer” or a “soothsayer” for “accurately” predicting the developments in the Philippine financial markets, so far. Albeit we don’t like to rent up a table space at the malls, spread out tarot cards and make use of astrology to inject events to spruce up on our forecasts, lest be accused of dislodging Madam Auring, whose role in the society’s division of labor we respect.

Our humble outlook is that we premise our views based on the most probable drivers of the markets rather jumble on supposed causalities or correlation which in the first place was less likely a factor after all.

For instance, we have been saying all along that the Phisix has been on an uptrend or advancing cycle primarily because of the inflationary-driven syndrome diffusing allover the world’s financial markets.

The so-called “Liquidity” factor is no other than the unprecedented scale of money and debt creation and intermediation that has filtered into almost every corner of the world markets or even among diverse asset classes.

Figure 1: Economagic: US Exploding Financial Sector debt

Aside from the Global Foreign Exchange Reserves held by Central banks as we previously discussed, in the US alone the credit owed by its Financial Sector has exploded massively to the upside in support of today’s buoyant global financial markets as shown in Figure 1.

Yet who among the laity would accept such abstract premise? Unfortunately because it is our natural tendency to look for simplified explanation for events we are inclined to dismiss such relevance and account for what is “sensational” rather than what really matters.

About Me

About Me 2.0

Trade the Philippine stock market.

For inquiries, my email address: benson.te@gmail.com

I am a licensed agent and trader-analyst for MDR Securities

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